In a significant GST decision, the High Court in Commissioner of Taxation v MBI Properties Pty Limited HCA 49 (“MBI Properties”) held that MBI Properties (“MBI”) as purchaser of a new residential premises which was a GST-free supply of a going concern and was subject to existing leases, was subsequently liable for GST under Division 135 of the GST Act.
The High Court decision does three things. First, it establishes the legal basis for charging GST on property leases created by a previous owner of the leased property. Secondly, it shows how the benefits of buying a going concern can be reversed under Division 135 of the GST Act where residential accommodation such as a hotel, is subsequently supplied. And thirdly, it offers a new interpretation of some key provisions of the GST Act and illustrates that a supply can arise by operation of law.
In this alert we work through how MBI’s arrangements to buy part of the Sebel Manly Beach Hotel were dealt with by the courts up to and including the significant decision of the High Court in MBI Properties.
Background - The Sebel Hotel arrangements
The previous owner of the hotel converted each room into strata lots and leased each lot to a management company. The management company, in turn, outsourced the hotel management to a hotel operator which ran the front desk under the Sebel brand. The operator made rooms available to guests. MBI then bought three of the rooms, so that it became the owner of three strata lots, each one leased to the management company.
The start of the litigation
The ATO originally contested in the separate but related case of South Steyne Hotel Pty Ltd v Federal Commissioner of Taxation (2009) 180 FCR 409 (“South Steyne”), a clause in the hotel room purchase agreements which attempted to give MBI a favourable fall-back position on GST. The clause was designed so that, if the going concern relief from GST did not apply on the purchase, then the benefit of the concessional margin scheme would apply. The outcome of that case was that, despite the convoluted drafting, the vendor and MBI had agreed (as the GST Act requires) that the sale of each room would be a GST-free supply of a going concern; a win for MBI as it had acquired everything needed to run an enterprise for each room.
Importantly for what was to occur later, it was also held that because each hotel room had its own strata lot, that the room was not a ‘hotel’ for GST purposes. Consequently, this meant that the rooms were an input taxed supply of residential premises with no GST payable on their rental.
The ATO’s next step
The contest between the ATO and MBI then took a new tack. The ATO effectively sought to reverse the effect of MBI’s successful GST-free acquisition of the rooms as going concerns by relying on an “increasing adjustment” under Division 135 of the GST Act; a rule designed to levy GST directly on the purchaser of a going concern where the purchaser intends to use that going concern to make supplies which are “input taxed”. Input taxed supplies are not subject to GST and, importantly, there is no credit for any GST the supplier has paid when making the input taxed supply.
The ATO relied on South Steyne which had held that the leases to the management company were input taxed supplies of residential premises. The ATO argued that this provided a clear basis for the increasing adjustment.
MBI’s position was equally clear. It agreed that the leases were input taxed supplies; but it argued that it was not MBI which had entered into the leases with the management company (the vendor had done this) and the hotel operator (not MBI) made the rooms available to guests.
The Full Federal Court agreed with MBI that an increasing adjustment under Division 135 could only be levied when the purchaser had made the supplies. Here the vendor had created the leases. The vendor had made the supplies. The “grant” of the lease was the only supply that could be made by way of lease. Further, the “architecture of the GST legislation” did not support the idea that there could be a continuation supply by one person of a supply made by someone else. It was irrelevant that GST on periodic rental income is to be paid over the life of the lease.
But more significantly, the result of the Full Federal Court’s approach was that the GST Act was potentially flawed. It appeared to follow from the Full Federal Court’s decision that a purchaser of leased commercial premises did not make any supply by way of lease and that its rental income could not consequentially be subject to GST.
The High Court decision
The ATO needed to establish two things; first, that it did not matter that a previous owner had granted the leases, secondly, that MBI intended to comply with the leases. The High Court accepted the ATO’s submissions. Consequently, MBI was liable to pay to an increasing adjustment under Division 135 of the GST Act equal to the GST avoided on its acquisition of the rooms as going concerns.
As a result of the High Court decision, we now have clarification of what has been assumed in practice; that a purchaser of leased premises is indeed obliged to pay GST on rents received, depending on whether the lease is characterised as a taxable supply or as input taxed.
In getting to this result, the High Court made a number of comments about the general operation of the GST Act.
First: the GST Act defines the key concept of “supply” mainly by examples. In MBI the High Court expands this, saying that, putting aside particular rules: “there is a supply whenever one entity (the supplier) provides something of value to another entity”. This substitutes “provides value” for “supplies”.
Second: on the supplier-acquirer relationship: “it is … wrong to consider that the making of a supply must always involve the taking of some action on the part of the supplier”. This means that a person can make a supply by operation of law. Here, MBI found itself in a relationship as landlord with the lessee by buying strata lots from the vendor, not by engaging with the lessee.
Third: bringing the first and second together: where a leasing relationship arises by operation of law, the supplier “provides something” to the lessee; namely “observing and continuing to observe the express or implied covenant of quiet enjoyment under the lease”. This reverses the Full Federal Court’s decision. It also suggests that both sides need to have outstanding obligations for a supply arising by operation of law to arise. Here, MBI provides the premises and the lessee pays ongoing rent.
Fourth: on intention to make supplies: this does not mean doing something new. Instead it extends to an intention “to observe an ongoing obligation”. Here, MBI intended at the time it bought the three hotel rooms to observe the obligations of a lessor.